Achieving your investment goals with factors: improve diversification

Factor-based strategies can help investors build better diversified portfolios. Third article of a series on how factors can help investors achieve specific goals.

Speed read

Diversification across asset classes called into question

Looking through the factor lens for a fresh perspective

Even with a factor approach, avoiding concentration risk remains key

The context

Diversification is often said to be the only ‘free lunch’ for investors. And for centuries, asset owners have applied this principle by dividing their holdings across different asset classes. But the dramatic increase in correlations between asset classes during the market wobbles of the 2000s, especially during the global financial crisis, has started to cast doubt on the benefits of traditional diversification.

One of the key debates today in the financial industry is whether quantitative approaches to portfolio selection and construction are more effective than traditional ones, in particular in terms of diversification. For instance, the influential 2009 study1 on the Norwegian Oil Fund and factor investing showed that despite a seemingly diversified profile, the fund’s active returns had large exposure to systematic risks, mainly due to bottom-up decisions.

The quest for more robust diversification techniques has caused many investors to turn to factor investing. In fact, a recent FTSE Russell survey of asset owners found that improved diversification ranked third among the top investment goals that lead them to consider factor-based strategies

Scientific grounding

Contrary to traditional asset allocation, which often lacks scientific grounding, factor allocation is based on decades of robust empirical analysis. This research documents a number of significant, persistent and relatively uncorrelated risk-return patterns across financial markets. Investors can take advantage of these patterns and select securities with different risk-return characteristics to achieve better diversification.

A 2012 paper2 by Antti Ilmanen and Jared Kizer analyzing market data on a number of asset classes dating back to 1927 reported that diversification into and across factors has been much more effective in reducing portfolio volatility and market directionality than traditional asset class approaches. And while the authors acknowledged that long-short investing generates the most diversification benefits, which implies short-selling and leverage, they also found meaningful benefits in a long-only context.

More recently, in a research report3 initially prepared for Robeco, Kees Koedijk and Alfred Slager, from Tilburg University, and Philip Stork, from VU University Amsterdam, also looked at the degree to which diversification can be achieved using a factor-based approach instead of an asset-based one. They argued that diversification across factors has major benefits, as the correlation between factors such as value or momentum is much lower than between investment categories.

The diversification benefits of factor investing are also evidenced by the performance of Robeco’s Multi-Factor Equities strategy over time. Figure 1 shows the simulated performance of a multi-factor portfolio over the period 1988 through 2015. It also shows which of the four factors (value, momentum, low volatility and quality) targeted in our quantitative equity strategies outperformed in each year.

Figure 1: balanced and stable outperformance

Source: Robeco, MSCI. Excess returns are measured relative to the MSCI World index from June 1988 through December 2015. Returns are measured in USD. The Robeco factor strategies are based on portfolio simulation and net of transaction costs of 75 bp. The factor weights in the multi-factor proposition are 25% Value, 25% Momentum, 25% Low-Volatility and 25% Quality. The bars show whether an individual factor strategy yielded a positive excess return in each year. The value of your investments may fluctuate. Past performance is no guarantee of future results.

Ultimately, the result is a balanced and stable outperformance, compared to the broader market (grey area), with positive contributions from at least three factors in three out of four full calendar years.

Other considerations

Although the focus should remain on optimizing factor exposures to ensure diversification, the merits of investing in a broad and varied selection of securities should not be forgotten. Robeco’s in-house research shows that adding sector weight constraints to an unconstrained portfolio reduces concentration risk while not significantly altering returns, at least to a degree. At a certain point, however, concentration limits start to have a negative effect on performance.

This implies that an optimal level of concentration exists, and this should be taken into account by investors. Efficient factor strategies should therefore not only focus on finding the best factor exposure, but also prevent unintended geographic or sector biases, as well as undue concentration on some single securities or sub-segments of the financial markets. One way to ensure this is to establish strict but workable concentration rules, as this would lead to a varied selection of stocks or bonds while avoiding excessive sector and country tilts.